The Bernanke Doctrine

Dec. 18 (Bloomberg) -- In a speech this week to celebrate
the Federal Reserve’s 100th birthday, Chairman Ben S. Bernanke
said one of the central bank’s greatest strengths is its
willingness, “during its finest hours,” to stand up to
political pressure and make tough decisions. To remind him that
those pressures aren’t new, Bernanke keeps in his office one of
many two-by-fours that construction industry workers mailed to
Paul Volcker to protest the former Fed chairman’s double-digit
interest rates.

To tame runaway inflation, Volcker had to crush the
construction business. That culture of political independence
freed Bernanke -- who conducted what may be his last news
conference as chairman this afternoon, and whose eight-year
tenure ends next month -- to break the central-bank mold just as
Volcker had done. He established what might be called the
Bernanke Doctrine, a two-part philosophy. First, use the Fed’s
balance sheet to do whatever it takes to stimulate a faltering
economy. With this new tool of monetary policy, he maneuvered
the U.S. away from another Great Depression. Second, put
financial stability alongside the Fed’s existing mandates of
price stability and full employment.

Along the way, he spurned the free-market, deregulatory
thinking of his predecessor, Alan Greenspan, and startled his
Republican political sponsors. Yet he earned the admiration of
colleagues and central bankers worldwide, many of whom are now
copying his moves. Underwater homeowners, underemployed workers
and underpaid savers may not see Bernanke as a heroic figure.
History most likely will.

Bernanke didn’t arrive at the Fed in 2006 intent on
revolutionizing central banking. Just the opposite: The economy
seemed strong, with unemployment at 5 percent and annual growth
of 3.3 percent. The housing bubble, however, was inflating
rapidly. The smartest economists, Bernanke included, failed to
see that the combination of undercapitalized financial
institutions, subprime loans, securitizations and exotic
derivatives could produce the lethal mix that crashed the global
economy. Bernanke’s Fed was responsible for regulating large
banks and home loans, and it failed.

What happened next redeems him. Bernanke recognized that an
economy running on credit would succumb unless the Fed fixed
broken credit markets, revived consumer demand and avoided
deflation. Using his deep knowledge of the mistakes of the
1930s, Bernanke set up one lending facility after another to
finance everything from commercial paper to auto loans. He
helped persuade Congress to adopt the Troubled Asset Relief
Program to bail out hundreds of banks. He made sure dollar loans
were available to overseas banks. He brought interest rates down
to near zero, and promised to hold them there indefinitely. To
make that commitment more credible, he put more of the Fed’s
deliberations on the record.

Granted, mistakes were made. Letting Lehman Brothers
Holdings Inc. fail was a big one. Bernanke and Treasury
Secretary Hank Paulson wanted to make an example of Lehman and
end the moral hazard that bailouts cause. That turned a
liquidity crisis into a full-blown panic.

By the end of 2009, the emergency had abated, but the
economy was still sick. So Bernanke’s Fed got even more
creative. With inflation hawks -- Republican lawmakers,
conservative economists and even some of his Fed colleagues --
screaming bloody murder, he started the first of three phases of
quantitative easing. The Fed bought enormous quantities of
Treasury bonds and mortgage-backed securities to depress long-term interest rates and induce investors to shift into other
assets. The Fed’s balance sheet grew from $1 trillion in 2008 to
almost $4 trillion, where it stands today -- greater than
Germany’s gross domestic product.

Today, as many had expected, Bernanke announced that the
pace of QE would be slowed -- though modestly, from $85 billion
a month to $75 billion a month, with further “measured steps”
to follow if the recovery continues as the Fed expects. He
stressed that while the Fed is still adding to its balance
sheet, it isn’t tightening monetary conditions: It’s still
adding stimulus, but from now on at a gradually diminishing
rate.

The policy worked. It energized the stock market, lowered
long-term interest rates, supported the interest-rate-sensitive
housing and auto markets, and cut unemployment -- not a lot, but
enough to quiet many critics, especially once they saw that
inflation remained tame.

Bernanke, meanwhile, backed the Dodd-Frank Act’s many
financial reforms. He agreed that large banks shouldn’t get
taxpayer subsidies in the form of lower borrowing costs because
of their “too big to fail” status. To prevent that, he
required the largest banks to hold more capital to absorb future
losses. He also required them to submit to rigorous stress
tests. More recently, the Fed threw its weight behind a stronger
Volcker Rule (to limit banks’ proprietary trading) than most
observers had expected.

The Fed chief also had the temerity to criticize Congress
for failing to devise a long-term deficit reduction plan coupled
with short-term stimulus. As the congressional dysfunction
worsened after 2010, QE was the only stimulus in town -- again,
to the chagrin of Republicans, who all but accused him of aiding
the enemy. He was right, and they were wrong.

Under Janet Yellen, the next Fed chief, the Bernanke
Doctrine is certain to prevail. The central bank will take its
mandate to reach full employment as seriously as the order to
keep inflation in check -- and will reach for new instruments,
if necessary, to do it. The Fed will strive with equal
determination to assure financial stability -- recognizing, in
effect, the third part of its new triple mandate.

Bernanke, scholar of the Great Depression, would not have
wished that expertise to be called upon. But it was, and the
U.S. can consider itself fortunate he was there.